Why do more items cost less relatively?

September 27, 2012 at 16:37

ink printerHave you ever wondered why ordering 100 printed bags cost far more than 10,000?

Well, hopefully we have the answer here; it´s all about the sharing of the fixed costs of production. Our resident Business Management graduate, Paul Millington, is here to explain.

(Note: this won´t be a post for those who don´t like maths!)

Basically when it comes to any manufacturing process there are two types of cost involved: fixed and variable.

FIXED COST´s are those expenses that don´t change depending on the output (amount of items) and is constant whether 100 or 10,000 are ordered. Taking the bag example, fixed costs would include machine set-up and configuration, producing the pantones, accounting costs for processing the order (which is the same paperwork for 10 or 10,000) and various others. Here we´ll just take in to account the machine set-up costs.

VARIABLE COST´s on the other hand change with output. In this case the variable cost will be the price of the ink to print and the machine worker´s wage. There are far more that we could include such as transport, quality control etc. but we´ll keep it simple for now and just use two.

So let´s calculate some prices.

Variable costs of promotional products

Variable Cost 1 – Ink for Printing

In our example we will say that we need 2ml of ink needed to print one bag. 2ml of ink costs €0,005. Therefore to print 100 bags the ink will cost €0,50 (100x€0,005). To print 10,000 bags the ink will cost a total of €50,00. The key thing to note however is that whilst the total cost of the ink has risen, the price for ink per pen (2ml) still hasn´t changed – it´s still €0,005 whether you order 1 or 10, 100 or 10,000:

a)     100 bags = €0,005*100 = €0,50/100=€0,005 per bag

b)     10,000 bags = €0,005*10,000=€50,00/10,000=€0,005 per bag

(Note: in reality it´s a little more complicated because economies of scale will mean the more you order the relatively cheaper the ink becomes but for this example we will ignore this).

Variable Cost 2 – Worker´s Wage

To make it simple let´s say that each bag takes 1 minute to print. The worker is paid €12 per hour to manage the machine. In one hour a total of 60 bags could be printed. €12/60 bags an hour = €0,2 per bag. Now should you order 600 bags then that will take 10 hours (600/60) but the cost per bag will be the same: €0,2. This is because each bag takes 1 minute and each 1 minute means paying the worker €0,2.

The variable costs whilst changing in total (worker: 12bagsx€1 = €10, 60bagsx€1= €60) do not change the individual unit price – workers wage is €1 per bag.

a)     100 units = €0,20*100 = €20,00/100=€0,20 per bag

b)     10,000 units = €0,20*10,000=€20,000/10,000=€0,20 per bag

So if the price decrease doesn´t come from the VC, from where does it come?

The relative price decrease for a greater quantity actually comes from the sharing of the fixed costs which are constant whether 100 or 10,000 pens are ordered.

Fixed costs of promotional products

Fixed Cost – Machine Set-Up

The example that we´ll use for our bag is the machine set-up. Configuring our machine, creating the pantones and print layouts is a fixed process and the time and cost aren´t dependent on the amount of goods being ordered.  Let´s say that to complete these tasks takes one hour and we pay the technician €1,000 per machine set-up (great job!). This set-up cost (€1,000) is the same for 100 or 10,000 units because we only have to set the machine up once to start printing.

The fixed costs (machine set-up) are as follows:

a)     100 units = €1,000/10 = €10 per bag

b)     10,000 units = €1,000/10,000= €0,10 per bag.

average fixed cost curve for promotional products

Total Price of the Bag

We´ll now calculate the total costs for 100 and 10,000 bags using the prices calculated above.

Each bag costs €0,005 to print (ink) plus €0,20 (worker´s wage). The variable cost of each bag therefore is €0,205 whether you order 100 or 10,000.

For 100 bags the fixed costs work out at €10 per bag. And for 10,000 units the fixed costs work out at €0,10 per bag.

So the total costs (variable + fixed costs) are as follows:

100 bags: €0,205(variable cost) + €10 (fixed cost) = €10,205 per unit

10,000 bags: €0,205 (variable cost) + €0,10 (fixed cost) = €0,305 per unit.

 

As you can see there is quite a large difference! Simply put, the variance in price per unit between smaller and larger quantities comes down to the sharing of the fixed costs involved in the production process which are shared our between the amount of items. As simple as that! Therefore, the more you order, the cheaper each product becomes relatively.

You may have a look at further frequently asked questions.